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For many risk managers, the recent financial meltdown has left them questioning the veryessence of risk modeling, used by many since the 1990s to measure their firm’sfinancial risk. Investment firms have traditionally relied on fantasticallycomplex mathematical models for measuring the associated risk in their variousportfolios, primarily to reassure investors that all is well. However, theworldwide events of the past 18 months have, arguably, left the reputation of riskmodeling in tatters. Here, Xavier Bellouard, co-founder of Quartet FS, explainswhat the future holds for risk modeling and how the use of Value at Risk (VaR)in particular needs to evolve to enable more accurate risk management.

The painful lessons of recent times have shown that the risks taken by the largest banks and investment firms in much of the Westernworld were so excessive and foolhardy that they threatened to bring down thefinancial system itself. The system had relied on many mathematical models, butby far the most widely used is VaR. Built around statistical ideas andprobability theories that have been around for centuries, VaR was developed andpopularised in the early 1990s by a handful of scientists and mathematicians or“quants”. VaR’s great appeal is that it expresses risk as a single number, apound figure, no less. Plus, it is the only commonly used risk measure that canbe applied to just about any asset class.

However, many would argue that the recent financial crisis was ultimately a crisis of modern metrics-based risk management. While undoubtedlyrisk modelling, as we know it, needs to evolve to better cope with market risk,one could argue that it is more banks’ and traders’ approach to, and use of VaR,that needs to change, rather than the actual model itself.

Historically, investment firms were using VaR primarily as a reporting tool to keep the regulators and shareholders happy, providing ‘afterthe fact’ analysis. Today, however, VaR must be viewed as an operational,rather than a reporting, metric. Firstly, VaR needs to be broken down andanalysed by traders. Instead of relying on a single number, traders need tolook beyond the top line, delve into the complex mathematical calculations andgain a better understanding of the type of risk they’re taking and how it can bestbe mitigated. In doing so, VaR willbecome a valuable management tool, alongside other factors, such as Profit andLoss.

Secondly, as well as better analysis, traders need to receive VaR calculations in a timely manner. When used simply as a reportingtool, receiving VaR calculations within 24 or 48 hours is adequate. However, iftraders are to have the ability to act on the information provided within theVaR calculation, they require the information much more quickly. While, real-timeVaR might not be necessary, within the trading day is crucial.

Of course, many of these considerations are currently being mandated by the regulators and the emerging regulations will not only require achange of mindset but also a review of banks’ systems. As it stands, manyfinancial institutions simply do not have the right technology in place todeliver in-depth VaR analysis in a timely fashion.

This is particularly true when you consider Marginal VaR. Marginal VaR is important as it analyses the impact – in terms of risk - of aparticular asset class or country, for example, on the business. The MarginalVaR of a position with respect to a portfolio can therefore be thought of asthe amount of risk that the position is adding to the portfolio. CalculatingMarginal VaR is enormously beneficial as it allows traders to understand wherethe largest risk is sitting within the business. However, few traders use it atpresent as it is challenging to compute Marginal VaR rapidly without the righttechnology in place.